Industrial Builders (IB) is a successful commercial real estate...

Industrial Builders (IB) is a successful commercial real estate development company located in Canada. You, CPA, are the controller. IB's business is building and selling commercial real estate, and it prides itself on "building high-quality commercial real estate on budget, on time, all the time." It is a 30-year-old family-run business operated and owned by John, Mary, and Bill Harker, who are siblings and each own one-third of IB. They recently held the annual general meeting to review IB's financial statements. In the meeting, they also discussed the potential purchase of a division of Ellen Steel Co. (ES). They have provided you with excerpts from the meeting (Appendix I).

ES is a steel manufacturing company located in the same community as IB. ES has various divisions, including a division that manufactures rebar, a building material that IB purchases and uses extensively in its real estate construction business.

Since 2016, ES's rebar division has been losing money because the demand for rebar dropped drastically with the recession in the local area. Although ES's rebar division had higher sales in 2020 than the two previous years, the market is still unstable and it is currently unpredictable. ES has been overproducing products because it was not able to accurately predict market demand. The company, therefore, has excess inventory. ES has approached IB to determine if it would like to purchase the rebar division's assets so that ES can expand its other lines of business.

ES is asking $3.0 million for the assets of its rebar division, and has provided its financial information (Appendix II). The division's management team is willing to stay on as employees and continue running the operation if IB acquires the division. The Harkers have asked you to prepare a report providing your detailed analysis of the specific concerns raised in the annual general meeting (Appendix I), with respect to the possible acquisition of the rebar division.

EXCERPTS FROM ANNUAL GENERAL MEETING

February 3, 2021

John: I'm happy to report that, for the fifth year in a row, IB has achieved an operating income of

$1 million. Now we have an opportunity to grow our business with the possible purchase of ES's rebar division. While we have no experience in manufacturing, I think we all agree that purchasing ES's rebar division is a great way to enhance our profitability.

Bill: Well, it might help our profitability but first I want to know the breakeven point for this division on its own. I would also like to know the overall impact on our net income if we combined the operations. Mary, you mentioned we could save some money by combining the operations?

Mary: Yes, I think we could save $75,000 on administrative expenses by combining ES's admin with IB. While we don't know a lot about manufacturing, I think ES's management team is overpaid. We could hire new managers and save another $75,000. Lastly, we have idle storage space that could be used to store the rebar inventory and save $15,000 that is currently paid for external storage.

If we buy ES's rebar division, IB would get its rebar from ES, which would boost ES's sales volume and IB wouldn't be paying an external supplier for rebar. IB uses about five million linear feet of rebar per year for its regular business. Our project manager told me that IB signed a contract for a special project, so we will need 10 million linear feet of rebar in total for this year. ES has enough capacity to produce this amount of rebar without sacrificing ES's existing regular sales. Given this, I would like a forecast of ES's profitability.

John: The profitability of IB and ES will depend on the transfer price. For simplicity, I'd suggest using market price for now.

Bill: We will also need to see whether the asking price is reasonable. I think when evaluating the purchase price, we should use a weighted-average cost of capital of 9%, and a 10-year timeline sounds reasonable to me. I would like to see a discounted cash flow analysis.

John: We also need to know about any possible non-monetary benefits, risks and potential issues of purchasing the division.

Mary: Yes, good point. For example, we will need to keep in mind that we don't have any experience dealing with ES. IB has never purchased any product from ES because of Dad's relationship with Smith Rebar, another rebar manufacturer. ES's selling price is the same price we pay for rebar from Smith, so ES's rebar is competitively priced, but we have no idea what the quality is like

APPENDIX II

ELLEN STEEL CO.

FINANCIAL INFORMATION REBAR DIVISION

2018

2019

2020

Linear feet produced

13,500,000

14,000,000

14,750,000

Linear feet sold

13,000,000

13,000,000

13,500,000

Average selling price per linear foot

$0.310

$0.305

$0.315

Sales revenue

$4,030,000

$3,965,000

$4,252,500

Costs

Direct labour

$1,215,000

$1,288,000

$1,371,750

Direct materials

$1,728,000

$1,722,000

$1,888,000

Fixed manufacturing overhead

$ 770,000

$ 775,000

$ 780,000

Marketing, distribution, and customer service costs

$ 275,000

$ 290,000

$ 315,000

General, administrative, and financing costs

$ 300,000

$ 300,000

$ 300,000

Marketing, distribution, and customer service costs are fixed costs.

ES invests $100,000 in the rebar division every three years for equipment improvements and upgrades

what is the break even for the industrial builders case and the overall impact on net income if they combined the operations?